Unit-3

Capital Structure: The firm’s mix of debt and equity financing is called its
capital structure. In addition, capital structure is how a company funds its overall
operations and growth. Modigliani and Miller (MM), who showed that dividend payout
policy does not matter in perfect capital markets, also showed that financing decisions
do not matter in perfect markets.

Relevance and Irrelevancy theory:

(I) Relevance Theory (By Durand): According to Durand’s (1952) traditional
theory of capital structure, the value of firm can be affected by its capital structure. This
theory is based on following three key points:

(a) Net Income Approach: Debt is normally cheaper than equity, therefore, when more
debt is mixed with equity; the weighted average of the cost of total funds including
both debt and equity becomes lower, thereby increasing the value of a firm.

(b) Net Operating Income Approach: When more debt is used, the cost of equity is
increased because shareholders demand risk premium for higher debt financing. As a
result, the weighted average of the cost of total funds including both debt and equity
becomes higher, thus decreasing the value of a firm. The benefits of lower cost in debt
funding can partially or totally offset the increased cost of equity, thereby affecting the
value of a firm.

(c) Optimal Capital Structure Approach: The impact of capital structure on the value of
a firm depends on net balance between the benefits of debt financing (cost reduction)
and the increased cost of equity (risk reduction). The result of the hypothetical analysis
is that there may be an optimal capital structure where the value of firm can be
maximized, or the cost of capital minimized by adjusting the ratios of debt to equity.
The traditional approach, therefore, focuses mainly on the relative costs of debt and
equity and their associated impact of capital structures on the value of a firm.
(II) Irrelevance Theory (By Modigliani and Miller):
Modigliani and Miller (1958) demonstrated that under perfect market conditions,
capital structure (debt-equity ratio) has no effect on the value of a firm, and that the
value of a firm is mainly determined by the return of assets regardless of the mix of
capital structure. Their arguments were based on the following famous propositions in
perfect market conditions (Modigliani and Miller model, or MM model).
The market value of a firm is determined by capitalizing the firm’s expected return
appropriate to the risk class of assets independent of the firm’s capital structure.

MM’s (Modigliani and Miller) proposition 1: “The market value of any firm is
independent of its capital structure.” This proposition says that the capital structure is
irrelevant to the value of a firm. The value of two identical firms would remain the
same, and value would not be affected by choice of finance adopted to finance the
assets.

MM’s (Modigliani and Miller) proposition 2: The expected rate of return on the
common stock of a levered firm increases in proportion to the debt- equity ratio ( D/E ),
expressed in market value. The rate of increase depends on the spread between rA , the
expected rate of return on a portfolio of all the firm’s securities, and rD , the expected
return on the debt.
# These two propositions are discussed in unit 4 also.
What is Leverage?
Leverage, is an investment strategy of using borrowed money—specifically, the use of
various financial instruments or borrowed capital—to increase the potential return of
an investment. Leverage can also refer to the amount of debt a firm uses to finance its
assets.
The concept of leverage is used by both investors and companies. Investors use
leverage to significantly increase the returns that can be provided on an investment.

Financial Leverage: The use of fixed-charges sources of funds, such as debt and
preference capital along with the owner’s equity in the capital structure, is described as
financial leverage. The financial leverage employed by a company is intended to earn
more on the fixed charges funds than their costs.
Operating Leverage: A production facility with high fixed costs, relative to variable
costs, is said to have high operating leverage. High operating leverage means a high
asset beta. A business with high fixed costs is said to have high operating leverage.
Operating leverage is usually defined in terms of accounting profits rather than cash
flows and is measured by the percentage change in profits for each 1% change in sales.
Note that, PV (revenue) = PV (fixed cost) + PV (variable cost) + PV (asset), where PV
refers to present value.
Degree of Leverage: The degree of operating leverage (DOL) is defined as the
percentage change in operating income (or EBIT) that results from a given percentage
change in sales.

In effect, the DOL is an index number that measures the effect of a change in sales on
operating income, or EBIT.
Combined Leverage: It is a combination of financial and operating leverage. With
the help of it we can find out the effects of fixed operating cost and fixed financial
charges on operating profit and earnings per shares respectively. It measures the total
risk of a firm. If operating leverage is greater than financial leverage than firm should
try to reduce it to maintain the level of risk vice versa.
EBIT (Earnings Before Interest and Taxes): It a measure of a firm's profit that
includes all expenses except interest and income tax expenses. It is the difference
between operating revenues and operating expenses.
EPS (Earnings per share): Earnings per share (EPS) is a company's net profit
divided by the number of common shares it has outstanding. It indicates how much
money a company makes for each share of its stock and is a widely used metric for
corporate profits. It is the first step in deciding about a firm's capital structure. A higher
EPS indicates more value because investors will pay more for a company with higher
profits. The EPS is an important performance indicator but not a decision criterion.
In general, the relationship between EBIT and EPS is:
EPS = (EBIT - l)*(1 - t)/n,
Where: l = interest burden, t = tax rate and n = number of equity shares
EBIT-EPS analysis:
The EBIT-EPS analysis is the method that studies the leverage, in other words, EBIT-EPS
analysis is used for making the choice of the combination of the various sources. It
helps select the alternative that yields the highest EPS.
If assets financed with the use of debt yield a return greater than the cost of debt, the
EPS increases without an increase in the owners investment.
The EPS also increases when the preference share capital is used to acquire assets. But
the leverage impact is more significant in the case of debt as:
1. the cost of debt is usually lower than the cost of preference capitalization
2. the interest paid on debt is tax deductible.

The companies with high level of EBIT can make profitable use of the high degree of
leverage to increase return on the shareholders equity.

Note that:
• Under unfavorable conditions, i.e. when the rate of return on total assets is less
than the cost of debt, the EPS will fall with the degree of leverage.
• If the probability of earning a rate of return on the firm's assets less than the cost
of debt is insignificant, a large amount of debt can be used by the firm in its
capital structure to increase the EPS .
• If the probability of earning a rate of return on the firm's assets less than the cost
of debt is very high, the firm should refrain from employing debt capital.
Thus, the greater the level of EBIT and lower the probability of downward fluctuation,
the more beneficial it is to employ debt in the capital structure.

Financial break-even level: In case the EBIT level of a firm is just sufficient to cover
the fixed financial charges then such level of EBIT is known as financial break-even level.
It is such a level of EBIT at which only the fixed financial charges of the firm are covered
and consequently the EPS is zero. If the EBIT reduces below this financial break-even
level, the EPS will be negative.
The financial break-even level may be calculated as:
(i) If the firm has employed debt only (and no preference shares):
Financial breakeven EBIT = Interest Charge

(ii) If the firm has employed debt as well as preference share capital, then its financial
break-even EBIT will be determined not only by interest charge but also by the fixed
preference dividend:
Financial breakeven EBIT = Interest Charge + Pref. Div./(1 - t), Where t is the tax rate.
Shortcomings of EBIT-EPS Analysis: Even though the EBIT-EPS Analysis helps in
making a choice for a better financial plan, it has a few complications:

1. If neither of the two mutually exclusive alternative financial plans involves the issue
new equity shares, then no EBIT indifference point will exist. In plotting the graph of
EBIT and EPS, there would be no intersection.

2. Sometimes, a given set of alternative financial plans may give a negative EPS to cause
an indifference level of EBIT. However, this would be imaginary.
Indifference Point/Level: The indifference level of EBIT is one at which the EPS
under two or more capital structures are same. While designing a capital structure, firm
may evaluate the effect of different financial plans on the level of EPS, for a given level
of EBIT. Out of several available financial plans, the firm may have two or more financial
plans which result in the same level of EPS for a given EBIT, Such a level of EBIT at which
the firm has two or more financial plans resulting in the same level of EPS is known as
indifference level of EBIT.

The use of financial break-even level and the return from alternative capital structures
is called the indifference point analysis.

The indifference level of EBIT is a point at which the after tax cost of debt is just equal
to the rate of interest. It can be identified graphically by plotting the EBIT-EPS lines for
various financial plans. Also, this value of EBIT produces the same value of EPS for
different financial plans as mentioned before.

The indifference point can be found by mathematically solving the given equation for
EBIT:
(EBIT*- l1)(1-t1)/n1 = (EBIT*- l2)(1- t2)/n2
Where, EBIT*= EBIT indifference point between the two alternative financial plans
I1and l2 are interest expenses before taxes under finance plans 1 and 2
t = income-tax rate
n1 & n2 are number of equity shares outstanding after adopting financial plans1 and 2.

Example of EBIT-EPS Analysis:

Numerical: A company Eagles Limited has an existing capital of Rs. 100 lakhs raised
through 10 lakh equity shares of Rs. 10 each. The tax rate is 50%. The company plans to
raise additional capital of Rs. 100 lakhs for financing an expansion project. In this
context, it is evaluating two alternative plans: (i) issue of 10 lakh equity shares at Rs. 10
per share, and (ii) issue of debentures carrying 14% interest. What will be the EPS under
the two alternative financing plans for two levels of EBIT say Rs. 20 lakhs and Rs. 40
lakhs? Find the indifference point also.

Solution: Refer to table below –

Earnings Per Share Under Alternative Financing Plans
Equity Financing Debt Financing
EBIT: EBIT : EBIT: EBIT :
Rs. 20,00,000 Rs. 40,00,000 Rs. 20,00,000 Rs. 40,00,000
Interest - - 14,00,000 14,00,000
Profit Before Taxes 20,00,000 40,00,000 6,00,000 26,00,000
Tax Amount 10,00,000 20,00,000 3,00,000 13,00,000
Profit After Tax 10,00,000 20,00,000 3,00,000 13,00,000
No. of Equity Shares
20,00,000 20,00,000 10,00,000 10,00,000
(Total)
Earnings Per Share 0.50 1.00 0.30 1.30

The EBIT indifference point between the two alternative financing plans can be
obtained mathematically by solving the following equation for EBIT*:

(EBIT*- l1)(1-t1)/n1 = (EBIT*- l2)(1- t2)/n2

Where, EBIT*= EBIT indifference point between the two alternative financial plans
I1and l2 are interest expenses before taxes under finance plans 1 and 2
t = income-tax rate
n1 & n2 are number of equity shares outstanding after adopting financial plans1 and 2.
Applying the above equation, we have:

(EBIT*- 0)(1- 0.50)/20,00,000 = (EBIT*- 14,00,000)(1- 0.5)/10,00,000

0.5 x (EBIT*)x(10,00,000) = 0.5 x (EBIT*- 14,00,000)x(20,00,000)

10,00,000 x EBIT* = (20,00,000 x EBIT*) – (14,00,000)x(20,00,000)

(14,00,000 x 20,00,000) = 10,00,000 x EBIT* or EBIT* = 28,00,000

Thus the indifference EBIT level is Rs. 28,00,000